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Derwent to blossom in London

Derwent London is taking advantage of the continued demand for prime office space in and around London and, trading at a discount to forward net asset value, the shares look worth buying
November 26, 2015

Prime London office prices and rents have increased at a frenetic rate during 2015 and conditions continue to look favourable for next year. Derwent London (DLN), the largest London-focused real-estate investment trust (Reit), looks in pole position to benefit from this trend, thanks to its top-quality investment portfolio, a significant development pipeline and a robust balance sheet.

IC TIP: Buy at 3760p
Tip style
Value
Risk rating
Low
Timescale
Long Term
Bull points
  • Very low gearing
  • Strong development pipeline largely pre-let
  • Rental growth expected to accelerate
  • Adept at picking up assets off-market
Bear points
  • Rising development costs
  • Modest dividend

All but 2 per cent of Derwent's £4.6bn property portfolio is located in central London, which puts it in a great position to benefit from the excellent conditions in the heart of the capital. Despite several years of strong performance, there is no sign of a let-up in demand for top-notch London offices, while supply is expected to remain tight. The strong backdrop was reflected in the IPD index recording a 3.5 per cent third-quarter rise in prime London office capital values and a 2.9 per cent rent increase. As one seasoned chief executive recently remarked to us: "If you're thinking of moving into a bigger office in 2019, you'd better start looking now."

Derwent is making hay while the sun shines. In the first nine months of 2015 it let over half a million square feet (sq ft) of new office space, securing annualised rental income of £26.2m. What's more, average lettings have been 10.8 per cent ahead of estimated rental value in December last year. And Derwent's development arm has 398,000 sq ft under construction and a further 620,000 due to start by June next year. In the four projects due for completion this year, 92 per cent are already let, sold or under offer, which helps reduce some of the inherent risks associated with any property development.

There is also a considerable amount of revenue upside locked into the existing portfolio reflected by the so-called reversionary rate. This is the difference between the annualised contracted rent - £134.7m at the June half-year - and the amount of rent that could be generated if all properties were rented at current market rates, known as the estimated rental value (ERV). At the half-year ERV was £228.8m, which means there's potential for nearly £100m of extra income from re-lets and rent reviews.

DERWENT LONDON (DLN)
ORD PRICE:3,760pMARKET VALUE:£4.18bn
TOUCH:3,759-3,763p12-MONTH HIGH:3,888pLOW: 2,800p
FORWARD DIVIDEND YIELD:1.2%TRADING PROPERTIES:£26m
DISCOUNT TO FORWARD NAV:6%NET DEBT:24%
INVESTMENT PROPERTIES:£4.42bn

Year to 31 DecNet asset value (p)*Pre-tax profit (£m)*Earnings per share (p)*Dividend per share (p)
201218865350.133.7
201322645848.936.5
201429086250.739.7
2015*34778067.043.0
2016*39858873.946.5
% change+15+10+10+8

Normal market size: 500

Matched bargain trading

Beta: 0.69

*JPMorgan forecasts, adjusted NAV, PTP and EPS figures

Acquiring sites through off-market transactions has also helped Derwent avoid the expense of entering bidding wars for potential sites. One of the more astute acquisitions made in February was a site at 20 Farringdon Road. This has a number of tenancy agreements expiring this year, which provides the opportunity to re-let at higher rates. In the longer term, it should benefit from its position just opposite the new Farringdon Crossrail station, which is due to open in 2018.

When facing a strong market, there is always a temptation for companies to overextend themselves with borrowing. Derwent does not look in danger of falling into this trap and is helping to finance spending with adroit capital recycling. In fact, revenue generated by property disposals in the first half of the year exceeded the cost of acquisitions. As a result, the group's loan-to-value ratio remains extremely low at just under 20 per cent.

With the increased pace of construction, building costs have started to rise. Derwent has increased its estimates for capital expenditure, and where necessary eschewed fixed-price contracts. It expects cost price inflation to be around 10 per cent per year for at least the next two years, although so far these rises are being more than offset by rising rental income and asset appreciation.

As the table shows, underlying rent-based profit is expected to continue to show strong growth, although analysts are currently predicting that profit from property disposals (not reflected in the numbers in our table) may abate in coming years as the cycle becomes less reliant on capital growth and more focused on rent increases.